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The Beer Comes First

October 10, 2011

For decades, graduate students at M.I.T.’s Sloan School of Management have played The Beer Game, which involves no drinking but shows how small fluctu-ations in demand ripple through a multi-tiered distribution system, causing booms and busts, overstocks and outages. An M.I.T. institution, the game has stumped thousands of clever players.

Now Jim Koch, a Harvard man — B.A., M.B.A., J.D. — is rewriting the real-life beer game, upending rules that have governed beer sales since the repeal of Prohibition. Koch is the founder and executive chairman of The Boston Beer Company, the nation’s largest brewer of craft beers, defined as beers brewed without adjuncts such as rice or corn, for distinction and flavor rather than mass appeal. Since its founding in 1984, Boston Beer has pursued a straightforward strategy: make its Sam Adams brand the most consistently high-quality beer on the market. That has worked out pretty well: Though Boston Beer has less than a 1 percent share of the total U.S. beer market, it has a 20 percent share in craft brews, the industry’s fastest growing segment, and is nearly three times the size of its nearest competitor.

But good tasting beer is fresh beer, and here Koch’s simple strategy runs headlong into the three-tiered distribution system that is one of the lasting legacies of Prohibition. By law, producers of beer, wine and spirits must sell to wholesalers, who in turn sell to retailers and restaurants. To avoid out-of-stocks, as in M.I.T.’s Beer Game, wholesalers keep a month or two of inventory in their warehouses, at room temperature. Unlike wine, beer deteriorates with age, and that deterioration is accelerated at temperatures above 33 degrees Fahrenheit.

Many producers curse the three-tier system — and the lobbyists who help keep the law on the books — for enriching an unnecessary middleman at their expense. The National Beer Wholesalers Association maintains the nation’s third-largest political action committee, and since 2000, it has donated $15.4 million to candidates for federal office. Producers call it wholesale robbery.

But Koch, who spent several years at the Boston Consulting Group (BCG), frames the issue differently. He sees it as an exercise in supply chain management. Just as he once counseled Detroit automakers to adopt the lean manufacturing principles practiced by the Japanese, he is now working to turn the beer distributors into his partners, with an initiative he calls the Freshest Beer Program.

“The three-tier system exists,” Koch says in an interview at Boston Beer’s research brewery in the Jamaica Plain neighborhood of Boston. “Just like you need rain and sunlight to grow hops. You can’t just shake your fist at the sky. Distributors want to sell beer; they want to make money. They’re trying to run a good business. Assume that, and build on that.”

Toward that end, Koch is asking wholesalers to reduce the beer in their inventory from a month or two to just five days, and to keep it all refrigerated. Instead of estimating their needs and placing orders for 30 to 60 days ahead, participating distributors report their daily sales to Boston Beer, which supplies just enough each day to fill in their five-day supply. The concept is simple, the benefit to the beer drinker clear, but the execution is challenging, and the costs significant.

“By the end of the day, they know what their orders are for tomorrow,” Koch says. “They load the trucks overnight and ship it out. By five or six tonight, we’ll know what they’ll need tomorrow, so why not send them a truck on Thursday for what they delivered on Wednesday? Why not just replenish their inventory rather than using them as a buffer warehouse to stockpile inventory?”

One reason why not is that Koch’s system pushes inventory costs back into the brewery, which can no longer book the beer in the distributor’s warehouse as sales. Initiation of the program resulted in lower shipments in 2010 of approximately 50,000 case equivalents. Distributors faced the cost of adding or reactivating unused cold storage, but that was offset by the reduction in their warehouse space and the carrying cost of the excess inventory. The big costs were all on Koch’s end.

“Financially, it’s a real problem for us,” he said. “We have a big hit. It’s something like $15 million of profit that I have to give up.”

That’s just in 2010, when the program was piloted with five distributors. If Boston Beer successfully executes its Freshest Beer Program for 50 percent of its volume in 2011, the company expects that shipments growth would lag depletions growth by approximately two percentage points. Shipments are the brewer’s sales to wholesalers; depletions are the wholesalers’ sales to retailers. So why do it, and why aren’t shareholders up in arms?

“I’m the controlling shareholder,” says Koch. “At the end of the day, it’s the right thing for the beer. I think everyone involved with the company understands that we became the leading craft brewer because we put the beer first. We do what’s right for the beer, and the business will take care of itself. It always has.”

Koch is soft-spoken, his voice familiar from the homespun radio spots he has broadcast over the years, and he dresses more like the Outward Bound counselor he once was than the typical corporate executive. He drives a seven-year-old Honda Accord with hop leaves littering the trunk. But he is also a persuasive speaker, and when he presented the Freshest Beer Program to distributors, many were ready to listen.

“The program was explained to us, and it’s become one we wholeheartedly embrace,” said Joe Salois, owner and president of Atlas Distributing in Auburn, Mass. “If he gets it right, the headline will be ‘Beer Game Rules Changed.’ If he gets it right, it’s pretty phenomenal. We’ll have extremely fresh beer; we won’t be carrying excess product; the product will be stored cold and get to the consumer quicker. From a practical standpoint, it takes the ordering process out of our hands and puts it in the hands of Boston Brewing. It’s a new way of doing business.”

It is also a step few competitors will be willing or able to copy. “He’s tried to create both a win-win and a competitive advantage for Boston Beer over other suppliers,” said Ben Steinman, publisher of Beer Marketer’s Insights. The cost is considerable, “but they will become a favored supplier, because the distributors will make more money; they will have fresher beer out there, and it’s something that can’t really be duplicated because it would cost the majors so much more to do it.”

Tom Pirko, managing director of the beverage industry consultancy BevMark, said that Boston Beer and other craft brewers are now assuming the leadership of the beer industry the way Starbucks, Peets and other specialty coffee roasters took on the giants in that industry.

“Everyone is now lurching toward a new marketing paradigm that is for the first time aimed at distributing beer in the marketplace beyond flogging Bud Lite,” Pirko said. “Jim is really forcing the kind of change that will make them more productive, helping them rethink the way they do business. He’s probably helping them to grow.”

As a consultant, Koch used to tell clients that you only had a business if you could do something better or cheaper than the competition. As a brewer he knew he could never be cheaper than the big established players, so all of his strategy and analytics are focused on how to be better. In 1988, he became the first brewer in America to put freshness dating on the bottle, and Sam Adams very rapidly became the country’s best-selling craft beer. That move results in $4 million in returned beer each year, but it differentiates the brand. The Freshest Beer Program takes the concept further.

Beer degrades with time and temperature, the exogenous factors that cause the loss of fresh flavor and taste. The rate of degradation doubles with every 18 degree Fahrenheit rise in temperature. So from 32 degrees to 50, twice as much deterioration is happening; at 68, it’s four times as much; at 86, eight times. Boston Beer modeled the normal path of beer from brewery to consumer and gauged the expected temperature for every day in that process.

“The bottom line was that about 70 percent of the degradation happened in the wholesaler’s warehouse,” Koch says. “You could immediately eliminate 90 percent of that 70 percent by keeping a week’s worth of beer in the cooler.”

Nevertheless, the $15 million profit hit caused some consternation in the financial community, not to mention the additional costs Boston Beer faced for adding fermentation tanks to store theunshipped beer and sophisticated new I.T. systems to keep the whole process on track. While “just in time” inventory practices have become increasingly important to manufacturers in the past decade, no one in the beer industry had ever done anything like this, Koch said. “It is a complete reinvention of the beer supply chain, and we do it for one reason. It’s what’s best for our beer.”

It is also good for the supply chain. Lost in the producers’ whining about wholesale robbery is the fact that distributors also are vulnerable: to political pressures from consumer groups, and to the broader trend toward eliminating middlemen that has only been accelerated by the Internet.

“People love to bash the three-tier system, but if it goes away that’s a plus to the big brewers and a detriment to the small ones, because they could never duplicate it,” said Jean-Michel Valette, a member of Boston Beer’s board. “So he’s actually looking at ways to make it more viable, which is another kind of leadership. Jim strongly values his independence, and that independence has actually been of great value to the company. He’s the beacon of focus in the long term. He’s created a lot of value for people.”

Valette led the team at the investment bank Hambrecht & Quist that took Boston Beer public in 1995. It was an unusual offering because Koch insisted on making shares available to consumers, in addition to the institutional investors that usually buy most IPO stocks. So he added neck hangers to Sam Adams bottles with a 1-800 number at which consumers could order a prospectus, and more than 100,000 customers mailed in checks totaling $50 million. With only $10 million in shares allotted to Sam Adams customers, the bankers had to return $40 million, but an idea was born.

Bill Hambrecht, founder, chairman and C.E.O. of the investment bank, said Boston Beer provided the prototype for the Dutch Auction offering he later orchestrated for Google’s initial public offering (I.P.O.).

“Traditionally, the investment bankers claimed that all this demand was [from] flippers,” Hambrecht said, referring to investors who buy a stock for the short-term bounce after an I.P.O. “But we tracked it and found that after a year, more than half the shares remained with these investors. We asked ourselves, was this a one-time phenomenon or is this a real way of doing I.P.O.s? So we looked at it and said, how can you have a method of allocation that’s fair, and that’s how we got to the Dutch Auction.”

Remarkably, after 15 years, nearly 9,000 of the original consumer stockholders, who comprise about a third of the stockholders, still hold their 33 shares of common stock. It’s been a good investment: The 33 shares each purchased cost $231 then, but are worth about $3,036 today at recent prices.

With that kind of return, investors are more inclined to view Koch’s innovations in production and distribution as the added value they actually are in the long term, rather than the added cost they appear to be on the quarterly earnings statement. That same calculus has informed Koch’s strategy since he started the company in 1985.

Koch hadn’t gone to Harvard in order to follow his father, grandfather and four earlier generations of oldest sons into the beer business. But after six years at BCG, he realized he no longer wanted to be a consultant.

“I knew about brewing.” Koch said. “The epiphany was thinking about it from the consumer’s point of view: that you couldn’t get a great glass of beer in this large and wonderful country of ours.” The major brewers produced insipid “fast-food” beer, imports were often stale and skunky, and the few early microbreweries were inconsistent. “I knew I could make the best beer in America and give it to people fresh.”

While New Albion, Sierra Nevada and other pioneering craft brewers began as scaled-up home brewing operations, with the owner serving as C.E.O., C.F.O., brewmaster and bottle washer, Koch structured Boston Brewing differently. With the family recipe in hand, he contracted early production to large breweries with extra capacity. With his father’s industry connections, he approached the acknowledged master brewmaster of the day, Joseph Owades, the inventor of light beer. Not able to afford Owades’ salary, he gave him a 2 percent stake in the fledgling company, which would be worth about $24.4 million today.

Koch could make consistently good beer from the outset, but he faced another immediate problem. Boston Beer was so small that none of the established distributors would bother with it. Massachusetts law permitted Koch to distribute the beer himself to bars and retailers within the state, which he did with his old station wagon, but he had broader ambitions. To entice the distributors to carry his tiny brand, he created a dedicated sales force to sell the beer. All the distributors would have to do was deliver it.

“From the very beginning, I didn’t view other craft brewers as competitors,” Koch said. “My competition was ignorance and apathy: people who didn’t know or care about beer. If I could make people knowledgeable, I would have drinkers, so we put out the best-trained sales force in the industry. We focused on a small number of accounts that we could use to educate people, to make them knowledgeable. This was a whole different approach to building customer loyalty.”

Today Boston Beer has 300 salespeople, experienced in beers and brewing, who train wait staff, do tastings, and educate the trade and consumers about craft beer. New hires in the program still spend the first two hours of their first day on the job in a tutorial with Koch himself, who also continues to go on sales calls to retail stores, restaurants and bars.

“When a company gets bigger, you have this dichotomy where the senior people have the power to make decisions, but lack the information about what’s really going on, and the people closest to the customer have the information, but aren’t making the decisions,” Koch said. “Making sure that that gap doesn’t exist is crucial. Even now, I spend 40 percent of my time, two days a week, in the market.”

Spending time in the market, Koch made the unpleasant discovery that up to 15 percent of draft beers served, including Sam Adams, was not up to his quality standards. Some had been stored warm, others were delivered through dirty hoses, and many were poured into glasses that smelled of chlorine. In response, he assigned the sales force to perform draft audits, up to 20,000 tastings per year, to make sure his beer on tap tasted as good as it does at the brewery. In recent audits, less than 2 to 3 percent has fallen short.

“My responsibility does not stop when I put a beer on a truck and send it out from the brewery,” Koch said. “The reality is when somebody gets a bad glass of Sam Adams in San Francisco, they hold the brewer responsible. So we accept that responsibility, because frankly we’re the only person in the chain besides the consumer who cares.”

None of this is simple altruism. While total beer sales grew only 1 percent in 2010, sales of craft beer rose 11 percent, and those of Boston Beer rose 12 percent. Nevertheless, Koch cannot afford to rest on his laurels or take the brand’s preeminence for granted. Today, there are about 1,750 craft breweries operating in the United States. Koch estimates that more than 600 breweries are in the planning stages, and they could come on line in the next year or two.

So it is an exciting time for the craft beer revolution that Koch helped start, and he is enthusiastic about Americans’ embrace of the movement. But while few of these new breweries will match his quality or consistency, they will have the marketing advantage of their novelty, their mystique and above all, their “localness,” which has become the buzzword du jour in food and beverages.

Staying one step ahead requires more than fresher beer. Koch has introduced a rotating line of seasonal beers — richer and darker in the cold months, lighter and crisper in the warm — which allows him to put something new on retailers’ shelves every 12 weeks or so. And he’s also put together variety packs, which allow customers to sample several of the company’s diverse offerings, including 10 new beers just last year. It worked: Boston Beer set new sales records in each of the last five months of 2010.

On a more ambitious note, Koch has taken a page from the famous partnership between Robert Mondavi and Baron Philippe de Rothschild that resulted in the hyper-premium wine, Opus One. Boston Beer teamed with Weihenstephan in Germany, the world’s oldest brewery, to create a champagne-like brew called Infinium. They brewed only 13,421 bottles for sale in the United States, released just in time for the holidays, and drinkers were scrambling to find bottles.

In a similar vein, Koch worked with Riedel Glas Austria, the pioneer in varietal-specific wine glasses, to produce an ideal beer glass. One feature of the glass is a neck-and-lip design that helps sustain the head of the beer, which enhances the release of signature Noble hop aromas found in Samuel Adams Boston Lager. A laser-etched nucleation site within the glass maintains flavor release during the drinking experience.

Boston Beer now owns all its own brewing capacity, with production breweries in Pennsylvania and Ohio, in addition to the research facility in Boston. And by a quirk of consolidation and globalization, it is now the largest American-owned brewer. But Koch is still looking for ways to improve.

“Better is not a static thing,” Koch said. “We made the best beer in America in 1984. If we were still doing exactly what we were doing back then, now we’d be in the middle of the pack. You’ve constantly got to get better. You’ve got find opportunities to give your consumer a better experience.”

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Lawrence M. Fisher has written for The New York Times, Strategy + Business and many other publications. He is based in San Francisco.